“I’m surprised that you have never written about Fannie Mae’s new Payment Power program. It allows borrowers to skip payments, an option you have said was badly needed.”

I have indeed lamented the lack of payment flexibility in mortgages on many occasions. The Payment Power program (PPP), however, is a poor first step toward flexibility. I am not sure whether it will advance the cause or retard it.

The PPP allows a borrower to skip up to two mortgage payments in any 12-month period, and up to 10 over the life of the loan. When a payment is skipped, the amount is added to the balance and a new (slightly higher) payment is calculated over the period remaining to term. In effect, the lender is making an additional loan, equal to the payment, at the original loan rate.

This would be a nice option to have if it were free, but in fact it is very costly. Lenders charge both an upfront fee and a usage fee – some charge a high upfront fee and low usage fee and others do the opposite. I would look for the lowest upfront fee myself, since I wouldn’t expect to use the feature except in an emergency.

One of the lenders offering PPP is Indy Mac, which charges an upfront fee of only 1/8 of 1 percent of the loan. Its usage fees, however, are on the high side, ranging from $225 to $355, depending on the loan balance. As an example, the monthly payment on a 6 percent loan for $166,792 would be $1,000, and the usage fee (until the balance fell to $120,000) would be $295. That is an upfront charge of 29.5 percent to borrow $1,000 at 6 percent!

Paying $295 is better than becoming delinquent, but you would be far better off drawing on a home-equity line of credit (HELOC) if you have one. If you don’t have one, so long as you have unused equity in your home and your credit remains good, you can always get one. Just don’t wait so long that you become delinquent before the HELOC is approved.

Even better is having free insurance coverage for involuntary unemployment and disability, which you have now if you are paying for mortgage insurance and the carrier is MGIC. Under MGIC’s Mortgage Payment Protection Plan, within the first five years of your loan, MGIC will make your monthly payment up to $2,000 a month if you lose your job or become disabled for more than 30 days. The limit is nine monthly draws for a maximum payout of $18,000. Anyone covered by this plan would be foolish to pay anything at all for a Payment Power loan.

The premise underlying Payment Power is that the best way to provide a source of funds that a borrower can tap in an emergency is to allow him/her to borrow these funds, at very high cost. My view is that a truly flexible mortgage would provide a far better source of funds – one that borrowers generate themselves, by making larger-than-scheduled payments. If you pay more this month, you should be able to pay less next month.

This type of mortgage would base the borrower’s payment obligation on the loan balance. A schedule of required balances, declining month by month over the life of the loan, would be part of the contract. If the borrower made all the scheduled payments, his/her balances month by month would correspond exactly to the required balances. But if he/she paid more in some months, his/her actual balance would fall below the required balance, providing a “reserve account” that he/she could draw on by paying less later on.

Interestingly, the underwriting requirements for many existing loan programs require borrowers to demonstrate that they have a cash reserve equal to several months of payments. But once the loan is funded, the borrower is not permitted to build such a reserve by making payments in excess of the scheduled payment. That makes no sense. It also makes no sense that borrowers who prepay a chunk of their mortgage balance can’t reduce the payment instead of shortening the term.

The fact is that our current mortgage was not designed to facilitate mortgage management by borrowers. It was designed to facilitate servicing by lenders. This had a rationale when servicing was a manual procedure by guys with quill pens and green eyeshades, but it has no rationale today.

Next week, I’ll describe how a truly flexible mortgage, designed for borrowers in the computer age, would work. 

The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

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